2. Course details
Instructor: Kalle Ahi (MA)
Course credits: 3 EAP (20 contact hours)
Evaluation:
There will be 2 homeworks each (a 15% -> 2x15%=30% of grade)
First homework is due by the end of the course and the second before
y
a consultation)
The homeworks could be solved in teams (maximum of three persons
allowed to work together)
ll d k h )
The final exam consists of two parts: 1) theory (slosed book exam)
and 2) problem solving (open book)
2
3. About course web page
web-page
There is a course web-page based on moodle (in addition to
student information system – ÕIS)
d i f i
In order to access to the webpage:
First ti
Fi t time users should first register at th f ll i web page:
h ld fi t it t the following b
https://moodle.e-ope.ee/ (choose “create new account”)
Now, if y have successfully registered and logged in, please choose
, you y g gg ,p
Estonian Business School from the course categories list
From sub-categories choose FIN - Majandusarvestuse ja rahanduse
õppetool
õ t l
Now you should see: Managerial Decision Making and
Finances
The password for the course is:
From there you will soon find all relevant course information and
study materials (
d l (currently yet under construction)
l d )
3
4. Instructor
Kalle Ahi (MA, Prague CERGE-EI 2007, MA, University of Tartu
2002)
Currently doctoral studies at University of Tartu
Lecturing experience: courses of investments, financial
management, financial analysis, money and banking, micro- and
macroeconomics.
Since 2007 lecturer at Tallinn Technical University
Since 2009 docent at Mainor School of Economics
Currently also external expert for Enterprise Estonia
y p p
E-mail: kalle.ahi@gmail.com (please add course name on
the subject line), phone: (+372) 5644722
( 372)
4
5. Topics covered
1. Introduction to financial management; investment appraisal
tools d techniques. 6 h
t l and t h i hours
2. Financial reporting, different tools for financial analysis,
additional information resources, preparation statements for
resources
analysis. 2 hours
3. System of financial ratios and practical applications,
y p pp
decomposition of ratios, economic value added (EVA). 4 hours
4. Financial forecasting, different tools and techniques,
sustainable growth rate, financial valuation of a company. 4
i bl h fi i l l i f
hours
5.
5 Budgeting in a firm (master budget) applications of
budget),
management accounting in planning and evaluation of
performance) 4 hours
5
6. How would You characterise the main
objective of a firm?
6
7. ....and the answer is
and
Let’s look at what the gurus have to say to us:
g y
Van Horne: "In this book, we assume that the objective of the
firm is to maximize its value to its stockholders"
Brealey & Myers: "Success is usually judged by value:
Success
Shareholders are made better off by any decision which increases
the value of their stake in the firm... The secret of success in
financial management i to i
fi i l is increase value.“ l “
Copeland & Weston: The most important theme is that the
objective of the firm is to maximize the wealth of its
stockholders.“
Brigham and Gapenski: Throughout this book we operate on
the
th assumption th t th management's primary goal i
ti that the t' i l is
stockholder wealth maximization which translates into
maximizing the price of the common stock.
7
8. Value of a firm
Why maximising corporate profit is not a good objective for a
company??
There are many reasons:
Net i
N t income is actually an accounting figure th t is sometimes weakly
i t ll ti fi that i ti kl
related to actual cash the firm generates. Why?
Depreciation
p
For many firms, most sales are made under terms of credit, but
recognised as income
Also, the company itself may defer the payments to it’s creditors
Change in accounting principles (LIFO vs FIFO) may influence the
net income but should not have an effect on the value of the firm
(why?)
Creative accounting etc.
g
8
9. Financial function in a firm
To learn to see and analyse the connection between
different managerial decisions and their financial effect
effect.
Big picture of the FINANCIAL FUNCTION is based on a
balance sheet model of a firm:
Evaluate the value of the investment projects: forecast the
p j
relevant cash flows, evaluate projects based on several decision
criteria's (like net present value) and analyse the risks involved
(different scenarios etc ): FIXED ASSETS
etc.):
Evaluate different financing options the firm has and find an
optimal capital structure that minimizes the cost of capital the
firm
fi uses. INTEREST BEARING DEBT AND EQUITY
Make decisions about working capital in a firm. WORKING
CAPITAL (net current assets)
( )
9
10. Big p
g picture of corporate finance (Damodaran)
p ( )
Capital budgeting Weighted average cost
of capital (WACC)
10
11. Big picture (2)
The ultimate aim – increase the value of the firm.
Investments should be made to the projects where the return
is higher than the minimal acceptable hurdle rate
The value of the project depends on the amount, timing and riskiness
of the (incremental) cash flows
The projects that bear higher risk should have higher hurdle rate
(cost of capital)
The hurdle rate may also depend on the sources of financing (equity
and borrowings)
If there are no profitable use of capital within a firm the cash
firm,
should be returned to the shareholders.
11
12. Financial accounting vs corporate finance
Financial Accounting is the process of gathering, aggregating
and summarizing of financial data taken from an organization's
accounting records and publishing in the form of annual (or
more frequent) reports for the benefit of people outside the
f ) f h b fi f l id h
organization.
There are many differences between (f
Th d ff b (financial) accounting and
l) d
financial management – some of them are summarised in the
following slide
slide.
12
13. FIN.
FIN ACCOUNTING AND CORP FINANCE
CORP.
■ Measures the past and current ■ Future is important
standing of the company
■ Control and evaluation
■ Reporting
■ No particular rules
■ Accounting rules and laws
■ Consolidated information ■ Segmental information
■ Value is based on it’s accounting ■ Market value is important
g
balance sheet figure
■ Generally no risks analysed ■ Evaluation of risks is important
■ Equity doesn’t have a cost ■ Equity has (opportunity) cost
■ Net profit is important ■ Cash is King!
■ Is directed toward public ■ Is directed toward decision making
(stakeholders) outside the firm within a firm
13
14. “Equity doesn t have a cost”*
Equity doesn’t cost
Profit and loss account doesn’t includes opportunity costs of
equity.
e it
Even a positive net income could be insufficient from the
viewpoint of owners. The point can be described by well-known
well known
performance measure: EVA (economic value added)
Very simplified example: Total sales (10 mil), operating cash
expenses (8 mil), firm has outstanding debt 6 mil and equity 8
mil. The average interest rate for debt is 10% and the required
return on equity is 20%. Firm has made 14 mil of total
investments (incl. current assets).
Discuss, what could be the “economic profit” for a company.
(comment on the performance of the company)
* “Equity doesn’t have a cost” meaning that no interest is charged
from equity. Firm doesn t have to pay dividends also
equity doesn’t also.
14
14
15. 1st Topic: Capital budgeting
p p g g
Long term investment evaluation (capital expenditure) assumes
that the proceeds from an investment are spread over longer
time horizon.
The capital budgeting process involves three basic steps:
• Generating long-term investment proposals;
• Reviewing, analyzing, and selecting from the p p
g, y g, g proposals
that have been granted, and
• Implementing and monitoring the proposals that have
been selected.
b l d
Managers should separate investment and
financing decisions.
15
16. Capital Budgeting Decision Techniques
Accounting rate of return (ARR): focuses on project’s impact
project s
on accounting profits
Payback period: commonly used for small scale projects
Net present value (NPV): best technique theoretically;
difficult to calculate realistically
Internal rate of return (IRR): widely used with strong intuitive
appeal
Profitability index (PI): related to NPV
16
17. A Capital Budgeting Process Should:
Account for the time value of money;
A t f th ti l f
Account for risk;
Focus on (incremental) cash flow;
Rank competing projects appropriately, and
Lead to investment decisions that maximize shareholders’
wealth.
17
18. Example: Global Wireless
Global Wireless is a worldwide provider of wireless
telephony devices.
Global Wireless is contemplating a major expansion of its
p g j p
wireless network in two different regions:
Western Europe expansion
A smaller investment in Southeast U.S. to establish a toehold
18
19. Global Wireless
Initial Outlay -$250
Year 1 inflow $35
Year 2 i fl
Y inflow $80
Year 3 inflow $130
Year 4 inflow $160
Year 5 inflow $175
Initial Outlay -$50
Year 1 inflow $18
Year 2 inflow $22
Year 3 inflow $25
Year 4 inflow $30
19 Year 5 inflow $32
20. Accounting Rate Of Return (ARR)
Can be computed from available accounting data
Average pr ofits afte r taxes
ARR
Average in vestment
• Need only profits after taxes and depreciation
depreciation.
• Average profits after taxes are estimated by subtracting
average annual depreciation from the average annual
operating cash inflows.
Average profits = Average annual operating– Average annual
g
after taxes cash inflows depreciation
ARR uses acco ntin numbers, not cash flows;
ses accounting n mbers flo s
no time value of money. 20
21. Payback Period
The payback period is the amount of time required for the
firm to recover its initial investment.
• If the project’s payback period is less than the maximum
acceptable payback period, accept th project.
t bl b k i d t the j t
• If the project’s payback period is greater than the
maximum acceptable payback period, reject th project.
i t bl b k i d j t the j t
Management determines (
M td t i (sometimes arbitrarily) th
ti bit il ) the
maximum acceptable payback period.
21
22. Payback Analysis For Global Wireless
Management s
Management’s cutoff is 2.75 years.
Western Europe project: initial outflow of -$250M
But cash inflows over first 3 years is only $245 million
million.
Global Wireless will reject the project (3>2.75).
Southeast U.S. project: initial outflow of -$50M
S th tUS j t i iti l tfl f $50M
Cash inflows over first 2 years cumulate to $40 million.
Project recovers initial outflow after 2.40 years.
Total inflow in year 3 is $25 million. So, the project
generates $10 million in year 3 in 0.40 years ($10 million
$25 million).
Global Wireless will accept the project (2.4<2.75).
22
23. Pros and Cons of the Payback Method
Advantages of payback method:
• Computational simplicity
• Easy to understand
• Focus on cash flow
Disadvantages of payback method:
• Does not account properly for time value of money
• Does not account properly for risk
• Cutoff period is arbitrary
• Does not lead to value-maximizing decisions
23
24. Discounted Payback
Discounted payback accounts for time value.
p y
• Apply discount rate to cash flows during payback period.
• Still ignores cash flows after payback period.
g py p
Global Wireless uses an 18% discount rate.
Reject (166.2 < 250) Reject (46.3<50)
24
25. Net Present Value (NPV)
NPV:The sum of the present values of a project’s cash inflows
project s
and outflows.
Discounting cash flows accounts for the time value of money.
Choosing the appropriate discount rate accounts for risk.
CF1 CF 2 CF 3 CF N
NPV CF 0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
Accept projects if NPV > 0.
25
26. Net Present Value (NPV)
CF1 CF 2 CF 3 CF N
NPV CF 0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
A key input in NPV analysis is the discount rate.
r represents the minimum return that the project must
earn to satisfy investors.
r varies with the risk of the firm and /or the risk of the
project.
j
26
27. NPV Analysis for Global Wireless
Assuming Global Wireless uses 18% discount rate, NPVs
g ,
are:
Western Europe project: NPV = $75.3 million
35 80 130 160 175
NPV W t
Western Europe
E $ 75 .3 250
(1 .18 ) (1 .18 ) 2 (1 .18 ) 3 (1 .18 ) 4 (1 .18 ) 5
Southeast U.S. project: NPV = $25.7 million
S h US j $25 7 illi
18 22 25 30 32
NPV Southeast U .S . $ 25 .7 50
(1 .18 ) (1 .18 ) 2 (1 .18 ) 3 (1 .18 ) 4 (1 .18 ) 5
Should Global Wireless invest in one project or both?
27
29. Pros and Cons of NPV
NPV is the “gold standard” of investment decision rules.
Key benefits of using NPV as decision rule:
• Focuses on cash flows, not accounting earnings
• Makes appropriate adjustment for time value of money
• Can properly account for risk differences between projects
Though best measure, NPV has some drawbacks:
• Lacks the intuitive appeal of payback, and
• Doesn’t capture managerial flexibility (option value) well.
29
30. Internal Rate of Return (IRR)
IRR: the discount rate that results in a zero NPV for a project.
CF1 CF 2 CF 3 CF N
NPV 0 CF 0 ....
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
The IRR decision rule for an investing project is:
• If IRR is greater than the cost of capital, accept the project.
• If IRR is less than the cost of capital, reject the project.
30
32. IRR Analysis for Global Wireless
Global Wireless will accept all projects with at least 18% IRR.
Western Europe project: IRR (rWE) = 27.8%
35 80 130 160 175
0 250
(1 rWE ) (1 rWE ) 2
(1 rWE ) 3
(1 rWE ) 4
(1 rWE ) 5
Southeast U.S. project: IRR (rSE) = 36.7%
18 22 25 30 32
0 50
(1 rSE ) (1 rSE ) 2
(1 rSE ) 3
(1 rSE ) 4
(1 rSE ) 5
32
33. Pros and Cons of IRR
Advantages of IRR:
• Properly adjusts for time value of money
• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal
Disadvantages of IRR:
• “Mathematical problems”: multiple IRRs, no real solutions
• Scale problem
• Timing problem
33
34. Multiple IRRs
IRR
IRR
When project cash flows have multiple sign changes, there can be
multiple IRRs.
Which IRR do we use? 34
35. No Real Solution
Sometimes projects do not have a real IRR solution.
Modify Global Wireless’s Western Europe project to include a
large negative outflow (-$355 million) in year 6.
g g ( ) y
• Th
There i no real number th t will make NPV=0, so no real
is l b that ill k NPV 0 l
IRR.
Project is a bad idea based on NPV. At r =18%, project has
negative NPV, so reject!
g j
35
36. Conflicts Between NPV and IRR:
The Scale Problem
Th S l P bl
NPV and IRR do not always agree when ranking competing
projects.
The scale problem:
Project IRR NPV (18%)
Western Europe 27.8% $75.3 mn
Southeast U.S. 36.7% $25.7 mn
• The Southeast U.S. project has a higher IRR, but doesn’t
increase shareholders’ wealth as much as the Western
Europe project.
36
37. Conflicts Between NPV and IRR:
The Scale Problem
Th S l P bl
Why the conflict?
The scale of the Western Europe expansion is roughly five times
that of the Southeast U.S. project.
Even though the Southeast U.S. investment provides a higher rate of
return, the opportunity to make the much larger Western Europe
investment is more attractive
attractive.
Another (simpler example): Assume that before the
finance class starts two investment proposals are made to you:
A) invest 1 EEK and after a class you receive 2 EEK
B) invest 10 EEK and after a class you receive 12 EEK The projects
EEK.
are mutually exclusive
Which one you choose?
37
38. Conflicts Between NPV and IRR:
The Ti i
Th Timing P bl
Problem
The product development proposal generates a higher NPV,
whereas the marketing campaign proposal offers a higher IRR.
g p g p p g
38
39. Conflicts Between NPV and IRR:
The Ti i
Th Timing P bl
Problem
Because of the differences in
the timing of the two
projects’ cash flows, the NPV
for the Product
Development proposal at
10% exceeds the NPV for
the M k i Campaign.
h Marketing C i
39
40. Profitability Index
Calculated by dividing the PV of a project’s cash inflows by
project s
the PV of its initial cash outflows.
CF1 CF2 CFN
...
(1 r ) (1 r ) 2
(1 r ) N
PI
CF0
Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project PV of CF (yrs1-5) Initial Outlay PI
Western Europe $325.3 million $250 million 1.3
Southeast U.S. $75.7 million $50 million 1.5
• Both PI > 1.0, so both acceptable if independent.
Like IRR, PI suffers from the scale problem. 40
41. MIRR – modified internal rate of return
Addresses several shortcomings that IRR – method has (but has
no cure to the scales problem)
h l bl )
MIRR is a discount rate that equates the future value of the
project cash flows to the present value of investments
investments.
Where COFt – cash outflow at period t, CIFt – cash inflow at period t, k
– reinvestment rate (pos cash flows) of financing rate ( g
(p ) g (negative cash
flows; could be different k-s), n – project lifetime (years)
The MIRR for product development is 13,8% and marketing campaign
12,6%
12 6%
41
43. Capital Budgeting
Methods to generate, review, analyze, select, and implement long-
term iinvestment proposals:l
Accounting rate of return
P b k Period
Payback P i d
Discounted payback period
N Present Value (NPV)
Net P Vl
Internal rate of return (IRR)
P fi bili i d
Profitability index (PI)
Modified internal rate of return (MIRR)
Equivalent annuity (EAA) – later…
43
44. Cash Flow Versus Accounting Profit
Capital budgeting is concerned with cash flow
flow,
not accounting profit.
To evaluate a capital investment, we must know:
1. Incremental cash outflows of the investment (marginal
cost of investment), and
investment)
2. Incremental cash inflows of the investment (marginal
benefit of investment).
3.
3 The timing and magnitude of cash flows and accounting
profits can differ dramatically.
44
45. Cash Flows: Financing Costs and Taxes
Financing costs should be excluded when evaluating a
project’s cash flows.
Both interest expense from debt financing and
dividend payments to equity investors should be
excluded.
Financing costs are captured in the process of
discounting future cash flows.
g
Only after-tax cash flows are relevant as only such cash
y y
flows can be potentially distributed to investors.
45
46. Cash Flows: Noncash Expenses
Noncash expenses include depreciation, amortization, and depletion.
Accountants charge depreciation to spread a fixed asset’s costs over
time to match its benefits.
Capital budgeting analysis focuses on cash inflows and outflows
when they actually occur.
Non-cash expenses may (E
N h (Estonia i a special case) affect cash fl
i is i l ) ff h flow
through their impact on taxes:
Compute after-tax net income and add depreciation back, or
back
Ignore depreciation expense but add back its tax savings. (e.g. Depreciation tax shield)
In Estonia there is currently no tax shields (also including interest rate tax
y ( g
shield) - however, a realistic cash flow prognosis should take potential
future dividends into account through potential tax costs (for instance,
one can assume that an optimal debt/equity ratio is maintained and rest is
paid out as dividends etc.) 46
47. Working Capital Expenditures
Many capital investments require additions to working capital
capital.
• Net working capital (NWC) = current assets – current
liabilities
• Increase in NWC is a cash outflow; decrease in NWC is a cash
inflow.
• An example…
• O
Operate booth from November 1 to January 31
t b th f N b t J
• Order $15,000 calendars on credit, delivery by Nov 1
• Must pay suppliers $5,000/month, beginning Dec 1
p y pp $ , , g g
• Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10%
in Jan
• Always want to have $500 cash on hand
47
48. Working Capital for Calendar Sales Booth
Oct 1 Nov 1 Dec 1 J
Jan 1 Feb 1
Cash $0 $500 $500 $500 $0
Inventory 0 15,000 10,500 1,500 0
Accts payable 0 15,000 10,000 5,000 0
Net WC 0 500 1,000
1 000 (3,000)
(3 000) 0
Monthly in WC NA +500 +500 (4,000) +3,000
Payments and Oct 1 to Nov 1 to Dec 1 to Jan 1 to
inventory Nov 1 Dec 1 Jan 1 Feb 1
Reduction in $0 $4,500 $9,000 $1,500
inventory [30%] [60%] [10%]
Payments $0 ($5,000) ($5,000) ($5,000)
Net cash flow ($500) ($500) +$4,000 ($3,000)
48
49. Terminal Value
When evaluating an investment with indefinite life span the
life-span,
project’s terminal value is calculated:
Forecasts more than 5 to 10
Construct cash-flow forecasts years have high margin of
for 5 to 10 years error; use terminal value
instead.
i t d
• The terminal value is intended to reflect the value of a
project at a given future point in time.
• The terminal value is usually large relative to all the other
cash flows of the project.
49
50. Terminal Value
Different ways to calculate terminal values:
Diff l l i l l
• Use final year cash flow projections and assume that
all future cash flow grow at a constant rate (present value of a perpetuity);
• Multiply final cash flow estimate by a market multiple, or
• Use investment’s book value or liquidation value.
JDS Uniphase cash flow projections for acquisition of SDL Inc.
Year 1 Year 2 Year 3 Year 4 Year 5
$0.5 Billion
$0 5 B ll $1.0 Billion
$1 0 B ll $1.75 B ll
$1 75 Billion $2.5 Billion
$2 5 B ll $3.25 B ll
$3 25 Billion
50
51. Terminal Value of SDL Acquisition
Assume that cash flow continues to grow at 5% per year (g = 5%, r =
10%,
10% cash flow for year 6 is $3 41 billion):
$3.41
CF t 1 $3.41
PV t , or PV 5 $68.2
rg 0 10 0 05
0.10 0.05
• Terminal value is $68.2 billion; value of entire project is:
$ 0 .5 $1 $ 1 . 75 $ 2 .5 $ 3 . 25 $ 68 . 2
1
2
3
4
5
5
$ 48 . 67
1 .1 1 .1 1 .1 1 .1 1 .1 1 .1
$42.4 billion of total $48.7 billion is from terminal value! Caveat: Very
sensitive to terminal value (and hence growth rate)
• Using price-to-cash-flow ratio of 20 for companies in the same industry
as SDL to compute terminal value:
• Terminal Value = $3.25 x 20 = $65 billion
$3 25
• Caveat: market multiples fluctuate over time
51
52. Incremental Cash Flow
Incremental cash flows versus sunk costs:
I t l h fl k t
Capital budgeting analysis should include only
incremental costs.
• Simple example: assume that your company undertook a
market research and the costs were 200.000$. The market
k h d h 200 000$ Th k
research was successful and as a result, a more thorough
project evaluation is to be undertaken Should the costs of
undertaken.
marketing research be included into the cash flow budget or
not? Why or why not?
52
53. Opportunity Costs
Cash flows from alternative investment opportunities,
forgone when one investment is undertaken.
Some time ago You were thinking of attending the MA (MBA)
g g g ( )
program. Indeed you calculated the incremental costs and
benefits from attending business school. What are the
opportunity costs here?
i h ?
NPV of a project could fall substantially if opportunity costs
are recognized!
i d!
53
54. Cannibalization
Cannibalization refers to the loss of sales of an
existing product when a new product is introduced
and should be included as an incremental (negative)
d h ld b l d d l( )
cash flow.
• Cannibalization is a “substitution” effect.
• H
However there could be some exceptions to this
h ld b h
rule. One should take into account the effect of
potential competition.
l
54
55. Example of a project
A small bakery is planning to expand it’s activities and is going
to introduce a new product – “cheese cake”.
The expected sales are 40 000 cakes a year for every next 4 years.
Sales price is 4,00.-
The production cost is 1,80.- plus transportation costs 0,50.- per
cake.
k
The sales manager thinks that the introduction of a new product
could negatively affect the sales of other products and expects a loss
of 18 000.- (1.80.- per cake)
The firm has already made some expenditures for market research
y p
(20 000.-)
There is a small opportunity cost as the rooms that are now going
to be used were previously rented out for (5 000 a year)
55
56. Project (II)
An investment into equipment is 74 000.- (straight line
depreciation, no accounting salvage value after 4 years).
However the equipment could be sold for 10 000.-
The investment into net working capital is 15000.-
The incremental fixed costs are 15 000.- (mostly advertasing
costs)
The owners expect to pay out 60% of the net profit. Hence
according to Estonian tax system, the tax rate is (21/79)% from
dividends.
There is no general corporate tax on net profit
56
58. Capital Rationing
Can a firm accept all investment projects with positive NPV?
Reasons why a company would not accept all projects:
R h ld ll j
Limited availability of skilled personnel to be involved with all
the projects;
p j ;
Financing may not be available for all projects. Companies
are reluctant to issue new shares to finance new projects
because of the negative signal this action may convey to the
market.
k t
58
59. Capital Rationing
Capital rationing: project combination that maximizes
shareholder wealth subject to funding constraints
1. Rank the projects using Profitability Index (PI)
2. Select the investment with the highest PI
3. If funds are still available, select the second-highest PI, and
so on, until the capital is exhausted.
The t
Th steps above ensure th t managers select th
b that l t the
combination of projects with the highest NPV.
59
61. Equipment Replacement and Unequal Lives
A firm must purchase an electronic control device:
• First alternative: cheaper device higher maintenance costs, shorter period
device, costs
of utilization
• Second device: more expensive, smaller maintenance costs, longer life span
p g p
Expected cash outflows:
• Using real discount rate of 7%:
g
Device A’
D i A’s cash outflow < Device B’s cash outflow
h fl D i B’ h fl
select A? 61
62. Equivalent Annual Cost (EAC)
EAC converts lifetime costs to a level annuity; eliminates the problem
of unequal lives .
1. Compute NPV for operating devices A and B for their respective
lifetimes:
NPV of device A = $15,936
NPV of device B = $18,065
2. Compute annual expenditure (annuity cost) to make NPV of annuity
equal to NPV of operating device:
X X X
Device A $ 15 ,936 1
2
X $6,072
1 .07 1 .07 1 .07 3
Device B Y Y Y Y
$ 18 ,065 1
2
3
Y $5,333
1 .07 1 .07 1 .07 1 .07 4
• Since Device B’s annuity cost is lower, choose Device B.
62
63. Excess Capacity
Excess capacity is not a free asset as traditionally regarded by
p y y g y
managers.
• Company has excess capacity in a distribution center warehouse.
• In two years, the firm will invest $2,000,000 to expand the
warehouse.
The firm could lease the excess space for $125,000 per year
(at the beginning of each year) for the next two years.
• Expansion plans should begin immediately in this case to hold
inventory for new stores coming on line in a few months.
• I
Incremental cost: i
l investing $2 000 000 at present vs. two years from
i $2,000,000 f
today
• Incremental cash inflow: $125,000 (at the beginning of the year)
$125 000
63
64. Excess Capacity
NPV of leasing excess capacity (assume 10% discount rate):
125 ,000 2 ,000 ,000
NPV 125 ,000 2,000 ,000 2
$ 108 , 471
1 .10 1 .1
• NPV negative: reject leasing excess capacity at $125,000 per
year.
• The firm could compute the value of the lease that would
allow break even.
X 2 , 000 , 000
NPV X 2 , 000 , 000 2
0
1 . 10 1 .1
- X = $181,818 (at the beginning of the year)
- Leasing the excess capacity for a price above $181,818
would increase shareholders wealth.
ld i h h ld lth
64
65. The Human Face of Capital Budgeting
Managers must be aware of optimistic bias in the assumptions
g p p
made by project supporters.
Companies should have control measures in p
p place to remove
bias:
Investment analysis should be done by a group independent of
y y g p p
individual or group proposing the project.
Project analysts must have a sense of what is reasonable when
forecasting a project’s profit margin and its growth potential.
Storytelling: The best analysts not only provide numbers to
highlight a good investment, but also can explain why the
investment makes sense.
65
66. Cash Flow and Capital Budgeting
Certain types of cash flows are common to many
investments
Opportunity costs should be included in cash flow
pp y
projections
Consider human factors in capital budgeting
66
67. Choosing the Right Discount Rate
The numerators focus on project cash flows covered in
Chapter 9.
CF1 CF 2 CF 3 CF N
NPV CF 0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
The denominators are the discount rates (cost of capital)
Reflect opportunity costs to firm’s investors
The
denominator Reflect the project’s risk
p j
should:
Be derived from market data
67
68. Weighted Average Cost of Capital (
g g p (WACC)
)
Cost of equity applies to projects of an all-equity firm.
But what if firm has both debt and equity?
Problem is akin to finding expected return of portfolio.
Use weighted average cost of capital (WACC) as discount
rate.
• Lox in a Box is a chain of fast food stores
Lox-in-a-Box stores.
• Firm has $100 million equity (E), with cost of equity re = 15%;
• Also has bonds (D) worth $50 million, with rd = 9%.
• Assume that the investment considered will not change the cost
structure or financial structure.
D E 50 100
WACC rd re 9 % 15 % 13 %
DE DE 50 100 6850 100
69. Rules for Finding the Right Discount Rate
1.
1 When
Wh an all-equity firm invests i an asset similar t
ll it fi i t in t i il to
its existing assets, the cost of equity is the
appropriate discount rate
rate.
2. When a firm with both debt and equity invests in an
asset similar to its existing assets, the WACC is the
appropriate discount rate.
3. When the investment is more risky than the firm’s
average investment, a higher discount rate than the
WACC is required, and vice versa.
69
70. Sensitivity Analysis
Sensitivity analysis allows mangers to test the impact of each
assumption underlying a forecast.
•S
Sensitivity analysis involves calculating the NPV for various
l l l l h NPVs f
deviations from a “base case” set of assumptions.
GTI has developed a new skateboard. Base case assumptions yield
NPV = $236,000.
1. The project’s life is five y
p j years.
2. The project requires an up-front investment of $7 million.
3. GTI will depreciate initial investment on straight line basis for five years.
70
71. Sensitivity Analysis
GTI has developed a new skateboard. Base case assumptions yield
p p y
NPV = $236,000.
4. One year from now, the skateboard industry will sell 500,000 units.
5. Total industry unit volume will increase by 5% per year.
6. GTI expects to capture 5% of the market in the first year.
7. GTI expects to increase its market share by one percentage point each year after
year one.
8. The selling price will be $200 in year one.
9.
9 Selling price will decline by 10% per year after year one
one.
10. All production costs are variable and equal 60% of the selling price.
11. GTI s
11 GTI’s marginal tax rate is 30%.
30%
12. The appropriate discount rate is 14%.
71
72. Table 10-4 Sensitivity Analysis of
Skateboard P j t
Sk t b d Project
Dollar values in thousands except price
NPV Pessimistic Assumption Optimistic NPV
-$558
$558 $8,000,000 2. I i i l i
$8 000 000 2 Initial investment $6,000,000
$6 000 000 $1,030
$1 030
-343 450,000 units 4. Market size in year 1 550,000 units 815
-73
73 2% per year 5 Growth in market size
5. 8% per year 563
-1,512 3% 6. Initial market share 7% 1,984
-1,189
-1 189 0% 7.
7 Growth in market 2% per year 1,661
1 661
share
-488 $175 8. Initial selling price $225 960
-54 62% of sales 9. costs 58% of sales 526
-873 -20% per year 10. Annual price change 0% per year 1,612
-115 16% 12. Discount rate 12% 617
72
73. Scenario Analysis
Scenario analysis i a more complex f
S i l i is l form of sensitivity analysis.
f iti it l i
Rather than adjust one assumption up or down, analysts
calculate the project NPV when a whole set of assumptions
l l h j h h l f i
changes in a particular way.
For
F example, if consumer i
l interest in GTI’ new skateboard i
i GTI’s k b d is
low, the project may achieve a lower market share and a lower
selling price than originally anticipated
anticipated.
73
74. Monte Carlo Simulation
In M t C l i l ti
I a Monte Carlo simulation, analysts specify a range or a
l t if
probability distribution of potential outcomes for each of
the model’s assumptions.
model s
• It is even possible to specify the degree of correlation between key
variables.
variables
• A simulation software package is then used to take random “draws”
from these distributions calculating the project’s cash flows (and
distributions, project s
NPV) over and over again.
• The simulation produces the probability distribution of project cash
flows (and NPVs) as well as sensitivity figures for each of the
model s
model’s assumptions.
74
75. Monte Carlo Simulation
The
Th use of M t C l simulation h grown d
f Monte Carlo i l ti has dramatically i th
ti ll in the
last decade because of steep declines in the costs of computer
power and simulation software.
The bottom line is that simulation is a powerful, effective tool when
used properly.
p p y
Simulation’s fundamental appeal is that it provides decision makers
with a probability distribution of NPVs rather than a single point
estimate of the expected NPV.
Simulations can be aided using specialised software. For instance
excel based crystal ball. We look at it the next time we meet.
75
76. Decision Trees
A decision tree is a visual representation of the
sequential choices that managers face over time
with regard to a particular investment
investment.
• The value of decision trees is that they force analysts to think
through a series of “if-then” statements that describe how they will
react as the future unfolds.
76
77. Decision Trees for Odessa Investment
Trinkle Foods Limited of Canada has invented a new salt substitute,
branded Odessa.
Trinkle is deciding whether to spend 5-million Canadian dollars (C$) to
test-market a new line of potato chips flavored with Odessa in Vancouver.
Depending on the outcome, Trinkle may spend an additional C$50 million
1 year later to launch a full line of snack foods across Canada.
If consumer acceptance in Vancouver is high the company predicts that its
high,
full product line will generate net cash inflows of C$12 million per year
for 10 years.
If consumers respond less favorably, cash inflows from a nationwide launch
is expected to be just C$2 million per year for 10 years.
Trinkle’s cost of capital equals 15 percent.
77
78. Decision Trees for Odessa Investment
If the test market is successful, the NPV of launching the product is C$10.23 million;
if the initial test results are negative, and it launches the product, it will have an NPV
of – C$39.96 million. 78
79. Decision Trees for Odessa Investment
• To work through a decision tree, begin at the end and then work backward to the
initial decision
decision.
• Suppose one year from now, Trinkle learns that the Vancouver market test was
successful:
• If the initial test results are unfavorable and it launches the product:
• We then evaluate today’s decision about whether to spend the C$5 million. The
expected NPV of conducting the market test is:
• Spending the money for market testing does not appear worthwhile.
79
80. Real Options in Capital Budgeting
Option i i
O ti pricing analysis i h l f l in examining multi-stage
l i is helpful i i i lti t
projects.
Embedded options arise naturally from investment.
Called real options to distinguish from financial options.
Value of a project equals value captured by NPV, plus option.
Options can transform negative NPV projects into positive
NPV!
80
81. Types of Real Options
Expansion • If a product is a hit, expand production.
options
Abandonment • Firm can abandon a project if not successful.
• Shareholders have valuable option to default on
options
p debt.
debt
Follow-on
investment • Similar to expansion options, but more complex
(Ex: movie rights to sequel)
options
• Ability to use multiple production inputs
Flexibility
y (example: dual fuel industrial boiler) or produce
dual-fuel
options multiple outputs
81
82. Strategy and Capital Budgeting
Competition and NPV
Advocates of a positive NPV project should be able to
articulate the project’s competitive advantage before
running the numbers
Otherwise in perfect financial markets for every project the
NPV should not generally exceed 0. (Why?)
0
Strategic thinking and real options
Managers must articulate their strategy for a given
investment
Many investments could have embedded options in them
y p
82
83. Risk and Capital Budgeting
All-equity fi
All it firms can di
discount th i standard i
t their t d d investment
t t
projects at cost of equity.
Firms with d b and equity can di
Fi i h debt d i discount their standard
h i d d
investment projects using WACC.
A variety of tools exist to assist managers in understanding the
i f l i i i d di h
sources of uncertainty of a project’s cash flows.
83
